“Is it true that a mREIT like Annaly Capital (NYSE:NLY) will be adversely impacted by rising interest rates and positively impacted by failing interest rates?”
Complicated question. I’ll answer in two parts: First, the direction of rates isn’t as important as the “spread” for mortgage real estate investment trusts. Secondly, rising rates do have other broad affects on the operations of mREITs — but there’s disagreement on whether those affects will be good, bad or a non-issue.
On mREIT Spreads
If you’re unfamiliar with high-yield mortgage REITs check out this recent article. In it, I wrote:
“Mortgage REITs aggressively borrow funds at a lower rate than the MBS they invest in and profit from the difference. The spread between their borrowing rate and the MBS yield is how they profit.”
Since both the rate at which mREITs borrow and the rate of return on their mortgage-backed securities are tied in some way to headline interest rates as set by the Federal Reserve, the only thing that’s true is if rates go up both will go up. The spread, however, is up for debate.
If the borrowing rate goes up faster than the rate of return, it’s bad.
If the yield on underlying the MBS portfolio goes up faster, it’s good.
It’s worth noting, too, that these are short-term loans to invest in long-term mortgage-backed securities. So if the Fed is taking actions like Operation Twist to depress long-term rates even as short-term rates remain fairly constant, then mREITs pay the same to borrow but get a smaller rate of return on their MBS portfolio.
In short, it’s not as simple as just look at the direction of rates. The devil is in the details.
On mREITS in a High-Rate Environment
Of course, there are other issues at play worth acknowledging.
Some are afraid higher interest rates will bring down mREIT book values and market caps — thus scaring off investors. There is an inverse relationship between interest rates and MBS values, since they are bond-like securities. When rates go down, values go up; when rates go up, values go down. That means the net value of mREIT assets will naturally decline with rising rates.
Others believe that interest rates are simply a factor that must be managed or hedged against. John Gerard Lewis, of Gerard Wealth Management, had a great article recently that discussed how the best mREIT managers at companies like American Capital Agency (NASDAQ:AGNC) and Annaly Capital Management are already looking ahead to a higher interest rate environment and plotting their strategies. It’s a question, then, about which mREITs are benefiting from being in the right place at the right time and which ones are looking to stay on top even when conditions are less favorable.
“The ups and downs of interest rates will affect, but not dictate, the fortunes of mREITs,” he writes. “They are not teetering on an interest-rate precipice and ultimately doomed. The industry is prospectively here to stay, and each firm’s management will determine its own level of success.” (Read the full John Gerard Lewis article here)
Then there’s a question of how fast a change in rates will take hold of these highly leveraged businesses. A rapid change in the lending environment or interest rates due to a crisis (say, due to European sovereign debt) will be much more painful than a predictable change in the environment due to widely publicized Federal Reserve game plans.
In short, there are many “what ifs” out there. But frankly, there have always been a lot of questions surrounding mREITs with their unreliable payouts and the uncertainty of credit market stability and central bank intervention via QE3 or not.
I think we can all agree that interest rates will move higher eventually. The Fed has said many times that its window is 2014. So the question, then, is how all these other factors will change in the run-up to an interest rate change — and in the days afterward.
Unfortunately, that’s not a question with an easy answer.
Many people are enamored with the high yield of mREIT investments right now. But make sure you educate yourself on the nature of this business and the long-term and short-term challenges.
Just chasing dividends for dividends’ sake is a bad move — especially considering the volatility in distributions for this sector.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, Jeff Reeves did not own a position in any of the stocks named here.